Tim Hartford: Working out the job market

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If we want that to change, we will have to start looking for a suitable match

Supply and demand is a fundamental economic concept, and unemployment is a totemic economic problem. But apply the concept to the problem, and you will not get very far.

The logic of supply and demand says that if wages are high, lots of people will want to work, but few people will want to employ them; if wages are low, employers will be hungry to go hiring, but few people will want to work. At equilibrium, the number of hours available equals the number of hours people are willing to work. Unemployment is impossible, unless there is a minimum wage -- this suggests, for instance, that unemployment was unknown in the UK before April 1 1999, which is not my recollection. The supply-and-demand approach offers little insight into job-market recessions, or why different countries have such different experiences of employment.

In this year's Royal Economic Society public lecture, Christopher Pissarides, winner of the Nobel memorial prize in economics in 2010, set out to resolve the mystery. Pissarides, along with Peter Diamond and Dale Mortensen, has developed a model of job-matching that has become the standard way macroeconomists think about labour markets.

The basic insight is nothing staggering. There are job-seekers in the world, and there are job vacancies in the world, and the aim is to match seekers to vacancies to create actual "jobs", which are matched pairs of former vacancies and former job-seekers. Searching for suitable vacancies, or suitable employees, is costly, and neither jobseeker nor employer knows whether any match will work out.

In such "search models", unemployment isn't a puzzle; it's the natural state of economic existence, just as being single is the natural state of romantic existence. All of us are born unemployed and single, and if we want that to change, sooner or later we will have to start looking for a suitable match.

Once Pissarides, Diamond and Mortensen began to write models that encapsulated some of these commonsense observations, they discovered a natural explanation for the "Beveridge curve".

The Beveridge curve is a simple downward-sloping relationship between the vacancy rate in an economy, and the unemployment rate. In good times, vacancies are plentiful and unemployment is low; in a recession, the economy slides down the Beveridge curve to a place where vacancies are scarce and unemployment is high. More interesting is the fact that the curve itself sits in different positions for different economies, and it can shift. The Beveridge curve in much of the EU is higher than that in the US, for instance -- for any given level of vacancies, there will be less unemployment in the US.

This fits a search-and-matching explanation. If the curve shifts outwards, with both vacancies and unemployment rising simultaneously, that is a sign of some kind of structural failure to match: there are potential jobs but for some reason, the match between vacancy and jobseeker is not occurring as quickly as usual. The US is showing signs of this structural stress: vacancies are on the rise but unemployment is falling more slowly than we would expect based on past experience.

Meanwhile, Germany, whose labour market has been defying the financial crisis, has enjoyed structural gains: unemployment has been falling even when vacancies have not been buoyant. Pissarides credits the delayed effects of Gerhard Schroeder's labour market reforms, with more flexibility and plenty of incentives to match young people with jobs.

The question, of course, is what feature of Germany's labour market has proved decisive in this -- and what we can transplant into other countries. Even a Nobel laureate was not able to give a convincing answer to that question.